5 things to know before co-signing a loan

Editor's note: This article by Brian O'Connell originally appeared on the website, CardRatings.com. It has been reprinted here with permission.

So you have excellent credit?

Good for you. A credit score of 700-and-above makes it easier and less expensive for you to buy a home, lease a car, start a business, or obtain any other type of financial credit.

But you can degrade or even ruin that credit -- or take a big hit in the pocketbook -- if you agree to co-sign a loan for a close friend or family member who can't get credit on his or her own. A study from the Federal Trade Commission shows that 75 percent of all sponsoring co-signers wind up paying the loan off themselves. In addition, the FTC says that creditors will pursue the signee with the stronger credit first if the loan falls into delinquency -- a direct threat to that strong credit score of yours.

Still, it's tough to say no to a loved one asking for a co-sign. So if you can't, here's what you should understand about the risks and rewards of allowing "piggybacking" on your good credit:

Knowledge is king

Right out of the box, the co-signer (that's you) needs to know that they are equally responsible for repayment of the loan, and that all activity will be reflected on their credit report. Therefore, if the person you've co-signed for has agreed to make the monthly payments, but doesn't, not only will the lender expect you to fulfill the obligation, but your credit report will reflect the negative activity. "For this reason, regardless of how close a friend or relative the person may be, it's wise to keep this arrangement business-like with all the 'what-ifs' discussed in advance of signing on the dotted line," advises Gail Cunningham, vice president at the National Foundation for Credit Counseling. "Otherwise, you could lose money, your good credit rating and the relationship with your loan partner."

You make the rules

As the loan partner with the stronger credit score, you have the most to lose in a co-signing arrangement. So use that leverage to lay down some basic rules of the road. For example, Cunningham notes the authorized user (your co-signee) has charging privileges on the account to which he or she has been added, but with no responsibility for payment. "On the up side, this is an ideal way for a person to build a credit file since activity will be reported in both names," adds Cunningham. "However, since the primary cardholder remains responsible for the charges incurred, if the authorized user reneges on holding up their end of the bargain, they run the risk of having to pay and having their credit report dinged." Thus, make sure your co-signee knows, going in, what the financial limits are on any loan arrangement.

Talk it out

Before you sign on the dotted line, have a candid conversation with your co-signee. Make sure he or she knows that the borrower tends to be the one who benefits from co-signing, and that benefit comes with big responsibility. "You might trust the person you are co-signing the loan for, but understand even if they the most trustworthy individual could find themselves in an unfortunate financial situation down the road that might limit their ability to make payments, which could result with you bearing that responsibility," says Leslie Tayne, a financial attorney and debt specialist at the Law Offices of Leslie H. Tayne, P.C. Tayne adds that, for any reason the borrower defaults, you bear the risk of having your bank accounts frozen, wages garnished, and credit score lowered. Also, if the borrower is unable to pay due to illness, handicap or death, it is the co-signer who inherit the responsibly for the loan.

In a recent report from the consumer advocacy group, TakeChargeAmerica.org, the group warns co-signers there may be "no going back" once you pull the trigger on loan. TCA advises weighing all potential issues, including the health and potential for job loss of anyone for whom you co-sign a loan. Also note that if your co-signer skips a payment, late fees and penalties can accumulate -- and that you could be liable for paying them.

Have an exit strategy

If opting to co-sign a loan, make sure you understand the terms and what the process is for getting yourself removed from the loan, if need be. "Note that while some loans do allow you to remove yourself as a co-signer, this is usually a lengthy process and is not likely to happen unless you have been on the loan for a while and the borrower is making regular payments towards the loan," advises Tayne.

Make no mistake, agreeing to co-sign a loan is serious business -- one that puts your credit and your savings at risk. So go into such an agreement with your eyes wide open and with full due diligence regarding the ongoing financial health of your loan partner.